Monthly Archives: May 2021
On May 6, 2021, new SEC Chair Gary Gensler made his debut, giving testimony to the House Financial Services Committee. Although Mr. Gensler is not new to regulatory leadership – he was head of the Commodity Futures Trading Commission (CFTC) – and as such, his style is certainly not new to capital markets participants, the testimony was nonetheless very enlightening of the mindset of the new SEC regime. The purpose of the testimony was particularly related to the market volatility in January, including GameStop and AMC, and reactions to that trading frenzy including Robinhood’s temporary trading restrictions, but over four hours, touched on much more.
From thirty thousand feet, Gensler attributes the January volatility to an intersection of finance and technology. On a more granular level, he highlights: (i) gamification and user experience; (ii) payment for order flow; (iii) equity market structure; (iv) short selling and market transparency; (v) social media; (vi) market plumbing – i.e., clearance and settlement; and (vii) system-wide risks, giving us a first look at potential areas of regulatory change and focus in the coming year.
This is a first look into Gensler’s points of interest and regulatory focus. Interestingly, Gensler’s SEC will obviously be much different than the agency under Clayton. Jay Clayton’s first speech focused on the SEC’s mission to protect Main Street Investors (see HERE), a mantra he continued throughout his regime. Although, I was (and am) a fan of Jay Clayton, I also believe that his policies had the unintended consequences of suppressing the under $300 million market cap class (see for example HERE and HERE regulator, his deep understanding of technology and focus on the bigger system could be a benefit to small and middle market enterprises.
Gamification and User Experience
As with all industries, mobile apps have expanded access to capital markets, making it easy and cost-effective to open accounts, trade, get wealth management advice and learn about investing. Gensler considers gamification as the use of game-like features, such as points, rewards, leaderboards and competitions, to increase customer engagement. Similarly, many apps enhance user experience with push notifications and social media features. Technology allows the designers and engineers to collect data that is used for predictive analytics and which then makes suggestions to users.
Although that technology exists across many platforms from shopping to fitness to entertainment suggestions, in the world of capital markets, the consequences can be more severe. As Gensler puts it, “[A] big loss could have immediate implications for the app user’s ability to afford their rent or pay other important bills. A small loss now could compound into a significant loss at retirement.” Moreover, the apps encourage users to trade more, which in and of itself increases risks and could lower long-term gains.
The SEC staff is in the process of preparing a request for public comment on the issues and the interface with current SEC regulations, including Regulation Best Interest. Moreover, the SEC will be considering new or updated rules that take into account recent technologies and communication practices.
As an aside, Mr. Gensler is not incapable of constructing and implementing an entire new rule set where one did not exist previously. While running the CFTC, Gensler directed the agency to create and then implement regulations for swaps. His tough stance earned him a divisive following with both strong opponents and proponents. I’m an advocate for clear rules and guidance as opposed to regulation through enforcement but as the saying goes, be careful what you wish for. As much as I like guidance, I would hate to see rules that squelched liquidity and opportunity for any investor class, especially the younger, technologically-savvy generation.
Payment for Order Flow
In the past few years, most broker-dealers have stopped charging fees for processing trades. To make up for this lost income, they make money by charging market makers for funneling order flow through them. The process is called payment for order flow. Robinhood reported $331 million of revenue for Q1 this year in payment for order flow – it is a big business.
Gensler breaks down payment for order flow into two categories: payment from wholesalers to brokers, and payment from exchanges to market makers and brokers. In a payment from wholesalers to brokers process, retail broker-dealers enter into agreements with wholesalers to purchase their order flow. Unlike public exchanges that must offer fair access to their publicly displayed quotes, these wholesalers can decide whether to execute these orders directly or to pass them along to be executed by the exchanges or other trading venues. Putting aside other aspects of this process, the data alone that the wholesaler garners is extremely valuable and provides a market advantage.
Gensler raises several other concerns, including a conflict of interest by brokers and an incentive to churn accounts or encourage more frequent trading. He points out that other countries, such as the UK and Canada, prohibit brokers from routing order to off-exchange market makers in return for payment. However, I do not believe that payment for order flow would create any additional conflict, and probably less so, than when a brokerage firm charges a straight-up commission on each trade. Rather, the issue becomes disclosure and ensuring best execution.
Case in point, in the recent settled SEC enforcement action against Robinhood, certain principal trading firms seeking to attract Robinhood’s order flow told them that there was a tradeoff between payment for order flow and price improvement for customers. Robinhood explicitly offered to accept less price improvement for its customers in exchange for receiving higher payment for order flow for itself.
Although Gensler points to this flaw in the system, I believe that requiring a firm to choose best execution over higher payments for order flow can at least partially resolve the issue. In my mind, the issue becomes, if a brokerage firm cannot charge for trades because of competition and cannot charge for order flow, they will be forced to find other income sources (such as selling data, advertising, increased proprietary trading, higher fees on managed accounts, etc.). Hopefully, the SEC will have a clear picture of what those other sources may be, and the potential negative consequences, when considering future policies and rulemaking.
Equity Market Structure
Gensler breaks the equity markets down to three segments: the national exchanges; alternative trading systems (ATSs), also called dark pools); and off-exchange wholesalers. In January, the national exchanges accounted for 53% of volume; ATS trading was 9% and wholesalers accounted for 38%. Of that 38%, only seven wholesalers accounted for the vast majority of volume. Citadel Securities alone represented 47% of all retail volume.
Gensler raises several concerns including potential fragility, lack of healthy competition, and limits on innovation. He has asked the SEC staff to look closely at the matter to make policy recommendations.
Gensler is not the first SEC Chair to be concerned with the state of the equity market structure. In March 2019, then Chair Jay Clayton and Brett Redfearn, Director of the Division of Trading and Markets, gave a speech to the Gabelli School of Business at Fordham University regarding the U.S. equity market structure, including plans for future reform (see HERE). As noted in the speech, in 2018, the SEC: (i) adopted the transaction fee pilot; (ii) adopted rules to provide for greater transparency of broker order routing practices; and (iii) adopted rules related to the operational transparency of alternative trading systems (“ATSs”) that trade national market system (“NMS”) stocks. The new rules were designed to increase efficiency in markets and importantly provide more transparency and disclosure to investors.
Clayton and Redfearn also talked about a need for an overhaul of Regulation NMS. Regulation NMS is comprised of various rules designed to ensure the best execution of orders, best quotation displays and access to market data. The “Order Protection Rule” requires trading centers to establish, maintain and enforce written policies and procedures designed to prevent the execution of trades at prices inferior to protected quotations displayed by other trading centers. The “Access Rule” requires fair and non-discriminatory access to quotations, establishes a limit on access fees to harmonize the pricing of quotations and requires each national securities exchange and national securities association to adopt, maintain, and enforce written rules that prohibit their members from engaging in a pattern or practice of displaying quotations that lock or cross automated quotations. The “Sub-Penny Rule” prohibits market participants from accepting, ranking or displaying orders, quotations, or indications of interest in a pricing increment smaller than a penny. The “Market Data Rules” requires consolidating, distributing and displaying market information.
In December 2020, the SEC adopted some amendments to Regulation NMS, including the Market Data Rules (subject of a future blog). Also, related to equity market structure, in September 2020 the SEC adopted new rules completely overhauling Rule 15c2-11 and its related processes (see HERE. Those rules have a September 28, 2021 compliance date which is keeping firms like mine, and audit firms extremely busy in between the regular 10-Q and 10-K seasons.
Short Selling and Market Transparency
Although the Dodd-Frank Act directed the SEC to publish rules on monthly aggregate short sale disclosures and to increase transparency in the stock loan market, those rules are two of the 11 remaining rules required by Dodd-Frank that have not yet been completed. Gensler has directed the SEC staff to prepare recommendations for these rules.
In addition, turning to a topic he knows well, Gensler has asked the SEC staff to consider recommendations about whether to include total return swaps and other security-based swaps under new disclosure requirements, and if so, how. He believes that the March 2021 failure of giant family office Archegos Capital Management was fueled, at least in part, by the use of total return swaps based on underlying stocks and the significant exposure that the prime brokers had to the family office as a result. Archegos Capital Management imploded, losing its entire $20 billion in just 10 days.
As we all know, social media has officially intersected with the capital markets. On Reddit, individuals gather in online communities to discuss a variety of topics anonymously, including investing; the subreddit r/wallstreetbets has about 10 million members. Outside of Reddit, social media aspects of trading apps, and all social media sites, now have various capital market centered communities.
Of course, the obvious concern is the use of social media to engage in pump-and-dump activities and other market manipulation schemes. Allaying “big brother” feedback, Gensler specifically states, “[T]o be clear, I’m not concerned about regular investors exercising their free speech online. I am more concerned about bad actors potentially taking advantage of influential platforms.”
He also points out that institutional investors and their algorithms also follow these online conversations. Developments in machine learning, data analytics, and natural language processing have allowed sophisticated investors to monitor various forms of public communication to see relationships between words and prices – known as sentiment analysis. At this point, the SEC is monitoring and learning more about these practices.
Market Plumbing – Clearance and Settlement
The clearing process is what makes the markets operate. For more on the U.S. Capital Markets Clearance and Settlement Process, see HERE. Currently the settlement process takes two days – i.e., T+2 – a trade entered on Monday, settles on Wednesday. For more on the settlement cycle and T+2 rule, see HERE.
Clearinghouses have rules to cover the credit, market, and liquidity risk that is present during those two days. All members transacting with the clearinghouses need to post collateral, called margin, to cover potential losses. If the broker went bankrupt before the trade is settled, the clearinghouse would use such margin to back the deliveries and payments with the goal of not disrupting the broader financial system. In January, the rapidly changing prices, high volatility, and significant trading volume of the meme stocks prompted larger-than-usual central clearing margin calls on broker-dealers. Some of those broker-dealers, such as Robinhood, scrambled to secure new funding to post the required margin. A number of brokers, including Robinhood, chose to restrict additional buying activity by their customers in a variety of the meme stocks.
Using this as a backdrop, Gensler questions whether broker-dealers are adequately disclosing their policies and procedures around potential trading restrictions, whether margin and payment requirements are sufficient, and whether the broker can manage its liquidity risk.
Gensler has asked the SEC staff to look into these disclosure requirements and practices. He has also asked for recommendations regarding shortening the settlement cycle further. As an aside, it is thought with current technology the settlement cycle could now be shortened to T+1 and that with further adoption of blockchain-based technologies, settlement could occur simultaneously with the trade. Gensler is a proponent and he understands technology. Time is risk, and he supports a move towards T-0.
System Wide Risks
In general, Gensler points out that the January liquidity explosion highlighted areas of concern. Robinhood, for instance, didn’t have sufficient liquidity to meet margin calls and had to fundraise within hours to meet $1 billion-plus obligations, and several brokers chose to shut down customer access to trading. Several hedge funds also lost significant money during these events. He also points to the Archegos implosion and the losses incurred by its banking partners. Finally, the concentration of trading activity with Citadel and a few other major players increases system-wide risks.
The SEC’s latest version of its semiannual regulatory agenda and plans for rulemaking has been published in the federal register. The Fall 2020 Agenda (“Agenda”) is current through October 2020. The Unified Agenda of Regulatory and Deregulatory Actions contains the Regulatory Plans of 28 federal agencies and 68 federal agency regulatory agendas. The Agenda is published twice a year, and for several years I have blogged about each publication.
Like the prior Agendas, the Fall 2020 Agenda is broken down by (i) “Pre-rule Stage”; (ii) Proposed Rule Stage; (iii) Final Rule Stage; and (iv) Long-term Actions. The Proposed and Final Rule Stages are intended to be completed within the next 12 months and Long-term Actions are anything beyond that. The number of items to be completed in a 12-month time frame is down to 32 items. The Spring Agenda had 42 and the Fall 2019 had 47 on the list.
Items on the Agenda can move from one category to the next or be dropped off altogether. New items can also pop up in any of the categories, including the final rule stage showing how priorities can change and shift within months. Portfolio margining harmonization was the only item listed in the pre-rule stage in the Fall 2019 and Spring 2020 Agendas. It remained in that category, but the newest Agenda added prohibition against fraud, manipulation, and deception in connection with security-based swaps to the pre-rule stage moving it down in priority from the previous proposed rule category.
Sixteen items are included in the proposed rule stage, down from 19 in Spring 2020 and 31 on the Fall 2019 list. Amendments to Rule 701 (the exemption from registration for securities issued by non-reporting companies pursuant to compensatory arrangements) and Form S-8 (the registration statement for compensatory offerings by reporting companies) remain on the proposed rule list. In May 2018, SEC has amended the rules and issued a concept release (see HERE and HERE In November 2020, the SEC proposed new rules to modernize Rule 701 and S-8 and to expand the exemption to cover workers in the modern-day gig economy.
Amendments to the transfer agent rules still remain on the proposed rule list although it has been four years since the SEC published an advance notice of proposed rulemaking and concept release on new transfer agent rules (see HERE). Former SEC top brass suggested that it would finally be pushed over the finish line last year but so far it remains stalled (see, for example, HERE).
Other items that are still on the proposed rule list include mandated electronic filings increasing the number of filings that are required to be made electronically; additional proxy process amendments; amendments to Guide 5 on real estate offerings and Form S-11; electronic filing of broker-dealer annual reports, financial information sent to customers, and risk-assessment reports; amendment to the registration of alternative trading systems (ATS) for government securities; investment company summary shareholder report and modernization of certain investment company disclosures; amendments to the family office rule; and broker-dealer reporting, audit and notifications requirements. Also still in the proposed rule stage is a potential amendment to Form PF, the form on which advisers to private funds report certain information about private funds to the SEC.
Items moved up from long-term to proposed-rule stage include execution quality disclosure; and records to be preserved by certain exchange members, brokers and dealers.
New to the list and appearing in the proposed rule stage are the controversial amendments to the Rule 144 holding period and Form 144 filings. In December 2020, the SEC surprised the marketplace by proposing amendment to Rule 144, which would prohibit the tacking of a holding period upon the conversion of variably priced securities (see HERE). The responsive comments have been overwhelmingly opposed to the change, with only a small few in support and those few work together in plaintiff’s litigation against many variably priced investors. Many of the opposition comment letters are very well thought out and illustrate that the proposed change by the SEC may have been a knee-jerk reaction to a perceived problem in the penny stock marketplace. I wholly oppose the rule change and hope the SEC does not move forward.
Another controversial new item appearing on the proposed rule stage list is enhanced listing standards for access to audit work papers and improvements to the rules related to access to audit work papers and co-audit standards. In June 2020, the Nasdaq Stock Market filed a proposed rule change to amend IM-5101-1, the rule which allows Nasdaq to use its discretionary authority to deny listing or continued listing to a company. The proposed rule change will add discretionary authority to deny listing or continued listing or to apply additional or more stringent criteria to an applicant based on considerations surrounding a company’s auditor or when a company’s business is principally administered in a jurisdiction that is a “restrictive market” (see HERE).
Bolstering Nasdaq’s position, the Division of Trading and Markets and the Office of the Chief Accountant are considering jointly recommending (i) amendments to Rule 2-01(a) of Regulation S-X to provide that only U.S. registered public accounting firms will be recognized by the SEC as a qualified auditor of an issuer incorporated or domiciled in non-cooperating jurisdictions for purposes of the federal securities laws, and (ii) rule amendments to enhance listing standards of U.S. national securities exchanges to prohibit the initial and continued listing of issuers that fail to timely file with the SEC all required reports and other documents, or file a report or document with a material deficiency, which includes financial statements not prepared by a U.S. registered public accounting firm recognized by the SEC as a qualified auditor.
Fourteen items are included in the final rule stage, down from 21 on the Spring Agenda, including a few of which are new to the Agenda. Proposed rules to the Investment Advisors Act of 1940 regarding investment adviser advertisements and compensation for solicitation were added to the list appearing in the final rule stage. Although an amendment to the definition for covered clearing agency was adopted in April 2020, a further amendment to the definition related to security-based swaps dealers now appear in the final rule stage. Moved from proposed to final are amendments to the rules regarding the consolidated audit trail.
Still listed in the final rule stage is universal proxy process. Originally proposed in October 2016 (see HERE), the universal proxy is a proxy voting method meant to simplify the proxy process in a contested election and increase, as much as possible, the voting flexibility that is currently only afforded to shareholders who attend the meeting. Shareholders attending a meeting can select a director regardless of the slate the director’s name comes from, either the company’s or activist’s. The universal proxy card gives shareholders, who vote by proxy, the same flexibility. The SEC re-opened comments on the rule proposal in April 2021 (see HERE). Although things can change, final action is currently slated for October 2021.
Also, still in the final rule stage are filing fee processing updates including changes to disclosures and payment methods (proposed rules published in October 2019); use of derivatives by registered investment companies and business development companies; and market data infrastructure, including market data distribution and market access (proposed rules published in February 2020); and amendments to the SEC’s Rules of Practice. Administration of the EDGAR system moved up from long-term to the final rule stage.
Still listed on the final rule stage is the harmonization of exempt offerings. The SEC adopted final amendments updating the exempt offering rules and processes on November 2, 2020. I published a five-part blog on the series, including related to integration (HERE); offering communications (HERE); amendments to Rule 504, Rule 506(b) and 506(c) of Regulation D (HERE); Regulation A (HERE); and Regulation CF (HERE ). Likewise is the disclosure of payments by resource extraction issuers (proposed rules published in December 2019 – see HERE). However, final rules were adopted in December 2020.
Keeping with that trend, modernization and simplification of disclosures regarding MD&A, selected financial data and supplementary financial information remain on the final rule list. Those amendments were adopted in November 2020 (HERE). Further valuation practices and the role of the board of directors with respect to the fair value of the investments of a registered investment company or business development company remain on the final rule list although changes were enacted in December 2020. Amendments to certain provisions of the auditor independence rules which were adopted in October 2020 still appear on the list (see HERE). As noted at the beginning, the Agenda is current through October 2020.
Several items have dropped off the Agenda as they have now been implemented and completed, including some major overhauls such as: the modernization and simplification of disclosures regarding the description of business, legal proceedings and risk factors which were adopted in August 2020 (see HERE); financial statements and other disclosure requirements related to the acquisitions and dispositions of businesses which was finalized in May 2020 (see HERE); amendments to the rules governing proxy advisory firms (see HERE); amend the rules regarding the thresholds for shareholder proxy proposals under Rule 14a-8 (see HERE); amendments to the definition of accredited investor (HERE ); and the revamping of the 15c2-11 rules and process (see HERE).
Other items that dropped off the list as rulemaking was completed include procedures for investment company act applications; NMS Plan amendments; disclosure requirements for banking and savings and loan registrants, including statistical and other data; prohibitions and restrictions on proprietary trading and certain interests in, and relationships with, hedge funds and private equity funds; fund of fund arrangements; customer margin requirements for securities futures; and amendments to the whistleblower program.
Thirty-two items are listed as long-term actions (up from 30 in Spring 2020), including many that have been sitting on the list for years, including implementation of Dodd-Frank’s pay for performance (see HERE) which has sat on the long-term list for several years now.
Earnings releases and quarterly reports were on the fall 2018 pre-rule list, moved to long-term on the Spring 2019 list and up to proposed in Fall 2019 and Spring 2020. The topic has now been dropped down again to the long-term list. The SEC solicited comments on the subject in December 2018 (see HERE), but has yet to publish proposed rule changes and is clearly not making this topic a top priority. Clawbacks of incentive compensation at financial institutions which had previously been dropped are back on as a long-term plan.
Amendments to the custody rules for investment advisors moved from the proposed rule stage to long-term actions, as did amendments to Form 13F filer thresholds. Amendments to the 13F filer thresholds were proposed in July 2020, increasing the threshold for the first time in 45 years. Surprisingly, the proposal was met with overwhelming pushback from market participants. There were 2,238 comment letters opposing the change and only 24 in support. Although the SEC continues to recognize that the threshold is outdated, it seems to be focusing on other more pressing matters.
Also bouncing back to long-term after spending one semi-annual period on the proposed rule list are amendments to Rule 17a-7 under the Investment Company Act concerning the exemption of certain purchase or sale transactions between an investment company and certain affiliated persons.
Still on the long-term action list is custody rules for investment companies; asset-backed securities disclosures (last amended in 2014); conflict minerals amendments; corporate board diversity (although nothing has been proposed, it is a hot topic); Regulation AB amendments; reporting on proxy votes on executive compensation (i.e., say-on-pay – see HERE); stress testing for large asset managers; the modernization of investment company disclosures, including fee disclosures; and prohibitions of conflicts of interest relating to certain securitizations.
Executive compensation clawback (see HERE) which had been on the proposed rule list in Spring 2020 is back as a long-term action. Clawback rules would implement Section 954 of the Dodd-Frank Act and require that national securities exchanges require disclosure of policies regarding and mandating clawback of compensation under certain circumstances as a listing qualification.
Also still on the long-term action list are removal of certain references to credit ratings under the Securities Exchange Act of 1934; definitions of mortgage-related security and small-business-related security; broker-dealer liquidity stress testing, early warning, and account transfer requirements; requests for comments on fund names; additional changes to exchange-traded products; amendments to Rules 17a-25 and 13h-1 following creation of the consolidated audit trail (part of Regulation NMS reform); amendments to improve fund proxy systems; short sale disclosure reforms; credit rating agencies’ conflicts of interest; amendments to requirements for filer validation and access to the EDGAR filing system and simplification of EDGAR filings; and electronic filing of Form 1 by a prospective national securities exchange and amendments to Form 1 by national securities exchanges; and Form 19b-4(e) by SROs that list and trade new derivative securities products.
Several swap-based rules remain on the long-term list including end user exception to mandatory clearing of security-based swaps; registration and regulation of security-based swap execution facilities; and establishing the form and manner with which security-based swap data repositories must make security-based swap data available to the SEC.
New to the list are money market fund reforms; amendments to municipal securities exemption reports; and amendment to reports of the Municipal Securities Rulemaking Board.
The Office of the Advocate for Small Business Capital Formation (“Office”) issued its 2020 Annual Report and it breaks down one of the strangest years in any of our lives, into facts and figures that continue to illustrate the resilience of the U.S. capital markets. Although the report is for fiscal year end September 30, 2020, prior to much of the impact of Covid-19, the Office supplemented the Report with initial Covid-19 impact information.
Background on Office of the Advocate for Small Business Capital Formation
The SEC’s Office of the Advocate for Small Business Capital Formation launched in January 2019 after being created by Congress pursuant to the Small Business Advocate Act of 2016 (see HERE). One of the core tenants of the Office is recognizing that small businesses are job creators, generators of economic opportunity and fundamental to the growth of the country, a drum I often beat.
The Office has the following functions: (i) assist small businesses (privately held or public with a market cap of less than $250 million) and their investors in resolving problems with the SEC or self-regulatory organizations; (ii) identify and propose regulatory changes that would benefit small businesses and their investors; (iii) identify problems small businesses have in securing capital; (iv) analyze the potential impact of regulatory changes on small businesses and their investors; (v) conduct outreach programs; (vi) identify unique challenges for minority-owned businesses; and (vii) consult with the Investor Advocate on regulatory and legislative changes.
Despite the shift to virtual, the Office managed to attend or speak at numerous conferences, sit on panels, host roundtables and otherwise engage in a surprising number of events in 2020.
State of Small Business Capital Formation
The Office reviewed data published by the SEC’s Division of Economic Risk Analysis (DERA) and supplemented the date with figures and findings from third parties. According to the Annual Report, most capital raising transactions by small businesses are completed in secondary registered offerings ($1.5 trillion), followed by Rule 506(b) of Regulation D ($1.4 trillion), Rule 506(c) ($69 billion), initial public offerings ($60 billion), Regulation A ($1.3 billion), Rule 504 ($171 million), and Regulation CF Crowdfunding ($88 million). Another $1.2 trillion was raised in a variety of other exempt offerings such as Rule 144A, Regulation S and Section 4(a)(2) directly.
I note this represents a change since last year when the numbers were: Rule 506(b) of Regulation D ($1.4 trillion) followed by rule 506(c) ($210 billion), Rule 504 ($260 million), Regulation A ($800 million), Regulation CF Crowdfunding ($54 million), initial public offerings ($50 billion) and follow-on offerings ($1.2 trillion). Interestingly, the amount of registered offerings increased substantially (including Regulation A which is technically an exempt public offering) and the amount of once popular Rule 506(c) offerings dropped by more than half.
Both years fail to take into account the new exempt offering rules and structure which went into effect on March 14, 2021. My 5-part blog on the new rules can be found here broken down by topic – Integration (HERE), offering communications (HERE), Rule 504, 506(b) and 506(c) (HERE), Regulation A (HERE), and Regulation CF (HERE). My belief is that we will continue to see a big uptick in Regulation A. Regulation CF will also garner more interest due to the increased offering limits and ability to use special purpose vehicles (SPVs) to complete the transaction.
Not surprisingly, small and emerging businesses generally raise capital through a combination of bootstrapping, self-financing, bank debt, friends and family, crowdfunding, angel investors and seed rounds. Bank debt and lines of credit are generally personally guaranteed by founders and secured with company assets. Also, small and community banks are giving fewer and fewer small loans (less than $100,000) as they are higher-risk and less profitable all around.
Accordingly, angel investors are an important source of financing for small businesses. Angel investors are accredited investors that look for potential opportunities to invest in small and emerging businesses. In fact, almost all private-offering investors are accredited and angel investor financing has remained strong. The SEC amended the definition of accredited investor in August 2020 (see HERE) to add a few more categories of individuals and entities that qualify. I would like to see further expansion to the list including based on education level and professional expertise.
As the typical seed round is approximately $1.1 million, by the time a company reaches seed financing stage, it is generally a little further along in its life cycle. Following a seed round there is typically a Series A ($2-$15 million), Series B ($10 million ++), possibly a Series C (also $10 million ++) and finally IPO. Venture Capital funds often participate in the Series A and B rounds. However, 70% of VC funds are in the San Francisco, New York or Boston areas and many of those funds prefer to say local. Moreover, venture capital funds generally take a control position, or assert management control, and set a timeline for exit. That can cause a lot of pressure on a growing company. As a result, many groups such as family offices and other institutions that historically invested in venture capital funds are now investing directly in these growing companies. Covid-19 increased that impact with a drop of over 40% in the first quarter alone.
The industries raising the most capital include banking, technology, energy, manufacturing, real estate, and health care. Although private capital is raised throughout the country, the East Coast states and larger states such as California, Colorado, Florida and Texas are responsible for higher amounts of capital raised in aggregate. Regulation A is particularly popular in Florida, California and New York.
Although the Office’s fiscal year end only accounted for the first quarter of the Covid-19 crisis, the Report does discuss its impact. The economic impact was felt most acutely by founders and investors in historically underrepresented groups, in emerging ecosystems, and among smaller fund managers. Reduction in spending has been particularly harsh at businesses that require in-person interaction, such as retail, entertainment, transportation, personal services, food services and hospitality.
From January 2020 through September 2020, the number of small businesses decreased by 27% across the U.S. That number represents an average. The percentage decrease in certain states such as California, Texas, Alaska and states in the northeast was higher. Not surprisingly, the hardest hit industry was leisure and hospitality with a decrease of 37% in small businesses. Even those businesses that managed to stay open saw a dramatic decrease in revenue during the same period.
Those businesses that were able to adopt new technology and virtual processes have the best chances of surviving. As such, businesses in the fintech, ed tech, telemedicine and cloud computing and collaboration software have accelerated. In fact, in the midst of the pandemic, Americans started new businesses at the fastest rate in more than a decade. As with any crisis, entrepreneurs have spotted opportunity. Many of those businesses relied on Regulation CF for capital raising. During July and August of 2020, more money was raised through Reg CF online fundraising then in the full prior year.
IPOs have continued strong, flourishing despite, or maybe because of, a shift to virtual roadshows (see HERE for more information about virtual roadshows and roadshows in general). The Report notes many benefits of the virtual roadshow, including (i) shorter roadshows; (ii) decreased market risk due to the reduction in launch time; (iii) cost savings associated with travel, printing and employee time on the road; (iv) longer test the waters meetings; (v) greater visibility in pricing with prospective investors indicating interest earlier in the process; (v) increased accessibility with video conferencing allowing for access to a wider pool of investors; and (vi) more sophisticated and detailed disclosures. The Report does not opine on whether these systemic changes to the process will continue post pandemic, but I firmly believe they will.
While last year’s annual report glumly talked about the decrease in IPO activity and jumped on the news headlines of the time, this year, IPOs are way up. The number of IPOs increased by 51% and the amount of proceeds raised went up by 81%. Of course, a huge percentage of the increase is a result of the unprecedented increase in SPACs (for more on SPACs see HERE). However, business services, manufacturing, and banking and financial services all saw increased IPO activity. Only technology, health care and hospitality/retail saw a decline.
The new surge doesn’t make up for the prior years’ downturn. The number of public companies has decreased from a high of 7,414 in 1997 to 3,559 in 2020; however, during the same time period, aggregate market cap has almost doubled. The logical reason for that is the dramatic growth of public company giants over the same time period coupled with the trend towards waiting for an IPO until further in the company life cycle.
Women continue to found more start-ups than ever before, do it for less money, receive fewer bank loans and VC financing but, on average, generate more revenue. There has also been an uptick of minority-owned women start-ups. Interestingly, although revenue is up for all woman-owned businesses, the increase in revenues for Asian American woman owned businesses far outpaces that of other groups. Companies with women on their founding teams on average exited 1 year faster than all-men founding teams, returning capital back to investors faster.
Besides minority women, all minorities are increasing business ownership. Minority-owned businesses have even more difficulty accessing capital. They are three times more likely to be denied a loan, pay higher interest rates when they do get a loan, generally must start with far less capital and, as a result, are less profitable. With that said, while all-white founding teams raise the majority of funding rounds, when diverse founding teams do raise capital from VCs, they tend to raise more.
Covid-19 is not the only disaster creating challenges. Natural disasters (hurricanes, fires, tornadoes, etc.) have a significant impact on capital raising and business failures. Ninety-six percent of companies that are in geographical areas that are hit with a natural disaster see a decline in revenues, and 90% of business will fail within a year if they do not resume operations within 5 days.
Not surprisingly, there is less start-up activity in rural areas and lower amounts of capital raised. The problem is severe. Using some of its strongest language, the Annual Report states that the decline in community banks in rural areas is crippling access to early-stage debt for small businesses. Furthermore, many angel and VC groups limit investments to a particular geographical area, hence exacerbating the issue. Covid had a crippling effect. Employment in nonmetropolitan communities, including rural communities, is heavily concentrated in the services sector, which includes health care, food, administration, professional, arts, education, and management.
Education to Ease Challenges of Offering Complexity and Friction
Last year the Office recommended rule changes to modernize and clarify the exempt offering framework in line with what was then just a concept release on the subject. This year, following the adoption of those final rule changes, the Office is recommending education. Although the new laws are a simplification of the old system, securities laws, of any kind, are complex and difficult to navigate. It is unlikely that even the most well-intentioned business owner could do so properly without securities counsel, which is expensive. However, a well-educated client can use counsel more efficiently and certainly with less stress.
The Office recommends targeted educational programs that (i) provide information to help promote compliance with the federal securities laws; (ii) provide tools (forms possibly) and other information to understand the offering choices; and (iii) target different groups including minorities and those in rural communities.
Clear Finders Framework
Although the SEC proposed a conditional finder’s exemption (see HERE), the exemption remains a proposal and even if passed, leaves the arena needing more guidance and a much deeper bench of regulation. I have advocated in the past and continue to advocate for a regulatory framework that includes (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions. Although the SEC proposal does have bad actor prohibitions, it is limited to private companies, does not have a cap on the amount of the raise, and other than as related to the finder and his/her compensation, does not require specific disclosures.
Most if not all small and emerging companies are in need of capital but are often too small or premature in their business development to attract the assistance of a banker or broker-dealer. In addition to regulatory and liability concerns, the amount of a capital raise by small and emerging companies is often small (less than $5 million) and accordingly, the potential commission for a broker-dealer is limited as compared to the time and risk associated with the transaction. Most small and middle market bankers have base-level criteria for acting as a placement agent in a deal, which includes the minimum amount of commission they would need to collect to become engaged. In addition, placement agents have liability for the representations of the issuing company and fiduciary obligations to investors.
As a result of the need for capital and need for assistance in raising the capital, together with the inability to attract licensed broker-dealer assistance, a sort of black-market industry has developed, and it is a large industry. Despite numerous enforcement actions against finders in recent years, neither the SEC, FINRA nor state regulators have the resources to adequately police this prevalent industry of finders. The Office continues to encourage the SEC, as it has in the past, to provide certainty and to finalize a framework that delineates the legal obligations of persons who match small businesses with investors.
Small businesses also look for capital from private funds, such as venture capital funds and private equity funds that operate under various exemptions from registration. The increasing concentration of capital into larger, private funds has resulted in a growing unmet need among entrepreneurs looking for seed and early-stage capital, with larger funds finding it inefficient or lacking bandwidth to make multiple small investments.
The Office advocates for increased diversity among fund managers, the location of funds, and the size of funds. To achieve the goal, the Office encourages Congress and the SEC to explore initiatives to increase diversity among investment decision makers to help shift the pattern matching that historically has negatively impacted women and minority entrepreneurs.
Attractiveness of Public Markets
Over the years, the disclosure obligations of public companies have evolved and substantially increased in breadth. Although smaller reporting companies do benefit from some scaled disclosure requirements compared to their larger counterparts (see HERE), the costs of compliance are still high. Naturally, when considering whether to go public, companies weigh the increased compliance and reporting costs versus the ability to use those funds for growth. The Office states that this could be one of the larger reasons companies are choosing to stay private longer.
The Office notes that the SEC has been taking the initiative, via rule changes and proposals, to address these concerns. Many recent amendments to the rules emphasize a principles-based approach, reflecting the evolution of businesses and the philosophy that a one-size-fits-all approach can be both under- and over-inclusive. For my blog on changes to the management’s discussion and analysis section of SEC reports, see HERE and on business descriptions, risk factors and legal proceedings see HERE. The Office encourages further initiatives to incentivize public offerings, including through more liberal direct listing rules and continued use of SPACs.
Although overshadowed by all things ESG and SPAC related, a new Wall Street backed national exchange, the Members Exchange (MEMX), launched in Q4 2020 with ambitions to rival the NYSE and Nasdaq. In the same month, the long-anticipated launch of the Silicon Valley backed Long-Term Stock Exchange (LTSE) came to fruition. The MEMX, founded as a lower cost alternative to Nasdaq and the NYSE, started small, initially only trading the securities of 7 large cap companies including Alphabet and Exxon Mobil, but has since opened to all exchange traded securities.
The MEMX was backed by Blackrock, Charles Schwab, Citadel, Goldman Sachs, Bank of America, JP Morgan, E-Trade and Virtu, among others. These financial giants invested over $135 million into the platform and as such, have a vested interest in its success. They also have the power to direct significant trading activity onto the MEMX, where others will likely follow. In the 6 months since it went live, the MEMX has already locked in over 1% of the U.S. market share.
Just as retail trading activity has been forced to reduce its fees with the likes of Robinhood and E-Trade offering low-cost electronic alternatives, Wall Street expects the exchanges to reduce fees for market data and other services and is apparently forcing the issue with competition. The MEMX plans to undercut the big exchanges on price, initially giving away its data. Going further, the MEMX will pay out rebates that exceed its transaction fees, forgoing early profits in hopes of building a liquid marketplace.
Founded in 2012 by Silicon Valley heavyweights, the LTSE launched for all companies in Q3 2020. The LTSE is designed to support a longer-term vision for listed companies. All listed companies are required to maintain a series of policies that are designed to provide shareholders and other stakeholders with insight into their long-term strategies, practices, plans and measures. Although the Exchange Act still requires quarterly reporting, the LTSE concentrates on yearly and multi-year performance.
The MEMX and LTSE are not the only new exchanges. Also in Q4 2020, the new Miami based options exchange, the MIAX Pearl Equities, kicked off. The MIAX is a low-cost platform marketing itself as a tech savvy competitor to the NYSE and Nasdaq.
Even though new exchanges are a rarity, those that have developed in the past often fail because it is simply very difficult to move volume and participation from the NYSE or Nasdaq. Simply put, traders want to trade where they have the most counter-party choices. Even the Cboe Global Markets, which owns and operates the former BATS markets and is the third largest U.S. exchange, concentrates on ETF’s and ETP’s, thereby creating a niche for itself. Although the BATS does route approximately 15% of the NYSE/Nasdaq equities trading, it is not an equities IPO competitor. Keep in mind that regardless of what exchange an equity is listed on, Regulation NMS requires best execution and a single market structure for all US securities (see HERE).
The timing could be right for new exchanges as we see huge market shifts and expectations moving away from traditional Wall Street. Investors are frustrated with the existing system and feel it is time for competition, technological innovation and more efficiency. The rise of FinTech-based trading platforms such as Robinhood, social media driven stock picks (Reddit and GameStop), the current focus on all things ESG and the enormous shift into digital currency (Bitcoin) investing, together with the fact that the new exchanges are backed by big players, signals that the street is open to more options.